I’ve always envisioned the fiscal end game of the federal government as similar to the fate of, say, Circuit City, where creditors simply stopped lending to it because they no longer believed they would get repaid. The federal government cannot “go out of business,” however, so national leaders would have to soldier on, slashing spending to match the level of incoming revenue, regardless of the social or economic cost.
But the federal government does have options that Circuit City never had. Among those options: inflating the currency and/or repudiating the national debt. Economists are beginning to seriously explore these end-game scenarios.
One example is “Why Default on U.S. Treasuries Is Likely,” by Jeffrey Rogers Hummel, an economics professor at San Jose State University, writing in the Library of Economics and Liberty. Writes Hummel: “I believe … that the United States will be driven to an outright default on Treasury securities, openly reneging on the interest due on its formal debt and probably repudiating part of the principal.”
Hummel doubts that the government can inflate its way out of its dilemma: “Today’s investors are far savvier and less likely to get caught off guard by anything less than hyperinflation.” Unfortunately, he doesn’t fully explain the point. My argument is that financial capital is so hyper-mobile that investors will respond to any strong whiff of inflation by shifting capital to other nations that offer better risk-reward ratios. Any benefit of inflation to the federal government would be short lived. I suspect that Hummel would agree.
Regardless, as the U.S. approaches the financial end game some 15, 20 or 25 years from now, our central bankers undoubtedly will try the inflation strategy out of pure desperation. Thus, we can predict that the final meltdown will be accompanied by inflation, capital flight, a plunging dollar and skyrocketing interest rates as investors demand compensation for higher risk. However, we can be equally certain that an inflation gambit will buy only a few months or years of respite.
One other solution would be to raise federal taxes from the 20%-of-income level that has prevailed since World War II to something approaching European levels. Hummel is skeptical that will happen. Public resistance to higher taxes is so intense that politicians will follow the path of least resistance — borrowing — until investors foreclose that option. I tend to agree.
Of course, debt repudiation is a stop-gap solution, too. Repudiating principle or interest payments on our national debt might bring down the cost of carrying that debt, but it also means that no one will lend anymore money. In sum, no matter what flailing acts of desperation the federal government is driven to, the end result eventually will be the same: A drastic curtailment of the size of the federal government with all the disruption and pain that implies.